Phillips Edison & Company, Inc. (PECO) Earnings Call Transcript & Summary

So we'll start again. Welcome to the 3:30 p.m. session at Citi's 2022 Global Property CEO Conference. I'm Bryan Quinn with Citi, and I'm pleased here to have with us Jeff Edison, from Phillips Edison. This session is for Citi clients only. If media or other individuals are on the line, please disconnect now. Disclosures are available on the webcast and at the AV desk. [Operator Instructions] Jeff, I'll turn it over to you to introduce Phillips Edison and your management team that you have with you and give us a few opening remarks, and then we'll jump into Q&A.

Can everybody hear me right? First of all, thank you, everyone, for being here. We appreciate it. I'm Jeff Edison. I'm the CEO of Phillips Edison & Company. With me are our President, Devin Murphy; and our CFO, John Caulfield. This is our first in-person conference and the first in-person conference since our IPO in July of last year. For those of you who don't know, Phillips Edison & Company is a -- in the grocery-anchored shopping center business. We have what we believe is a differentiated strategy, which is buying shopping centers anchored by the #1 or #2 grocer in the market they're in. They are small format, average 115,000 square foot shopping centers, and they're focused on delivering necessity goods to everyday Americans. And that's what we build a business over the last 30 years in this field. We believe that it has the ability to provide outsized returns over time, and we've proven that over a sustained period of time, the 30 years that we've been building the business. And we're excited to be here and appreciate everyone being here.

Great. Jeff, our opening question that we ask in all sessions are is what are 3 reasons why investors should buy your stock today?

The 3 reasons I see are, one is the differentiated strategy we have. The fact that we deliver necessity goods to the average American is a niche that is not covered by really any of our peers. But it is the markets where the grocers make their money. We are Kroger's largest landlord. We're Publix's second largest landlord. And we believe that, that niche is a niche where you can get better returns out of the box. You can get better growth and then you can spend less CapEx. And when you put those together, you get better returns. And that's the -- what we think is the magic of the markets that we're in and we think that, that's one of the reasons that we think that, that's a really good investment. The other is we're necessity base. Necessity-based retail acts differently than a lot of other kinds of retail through the cycles and that with the uncertainty in the markets today, we think that, that is an advantage. And the third is that we're trading at a discount at multiple to the peers. We're trading at a discount to where the private markets are, and we think we're a good investment from that perspective as well.

Great. So there's a lot of strip center REITs out there. You mentioned one of the ways you're differentiated really with the necessity base. Can you speak to other ways that you're differentiated from your other peers?

I think it's the focus. We've been in this business for 30 years and kept that same focus. We continue to do that now as a listed public company and the sustained track record of being able to work in these markets, build a team of 300 associates who are focused on that niche gives us a competitive advantage when it comes to buying and then more importantly, executing in these markets, growing rents, filling up vacancy, doing redevelopment, all of that is contingent upon really understanding this business. And we like to think of the fact that we have almost 300 centers, but we compete in 300 different markets. Each one of those centers competes at the corner of Main and Main, and they compete against what's there. And to have a team that can actually focus and be really locally smart is one of the keys to our success.

Jeff, the other thing that I would add on a differentiator is the fact that our format is different. I mean we're in the neighborhood shopping center business. Our average center is 115,000 square feet. And then ex the grocer, our average tenant is 2,500 square feet. And if you look at where the leasing demand is coming from, from retailers in the U.S., today, 70% of the leasing volume is in footprint of 2,500 square feet or less. So our centers are well formated for where the leasing demand is coming from, from the retailers today.

Great. How do you think your competitive positioning has changed today versus pre-pandemic times?

There hasn't been actually a ton of change. I mean we actually got -- and surprising to us actually as well is that we got through the pandemic in a very strong way. I mean we had market-leading retention of our neighbors. We call our tenants, our neighbors. We had collections that were market leading, and we lost less than 1% occupancy during the entire pandemic. Today, we're at the highest level of occupancy we've been in the history of the company. So we're back well above the occupancy levels we were pre-pandemic.

Okay. Getting on with our opening questions, what do you think is the most important aspect of your story or the growth opportunity that is misunderstood by the market today.

I think it really revolves around understanding what the average American does as a consumer with further necessity goods. That's the part that we think is the part that is not understood. And we believe that, that's the reason we've been able to get outsized returns is that this market is underserved, and it's a very fragmented business where we've identified 5,800 centers across the country that we'd like to own. That's our target market to buy. That's about $180 billion business to consolidate. And we think that we have the team to be able to do that. Those centers are -- have the #1 or #2 grocer in it the right size that meet our format, and we think that, that is a way that the market doesn't appreciate the opportunities in those markets and we're -- we like that back.

So in order to do that, we're going to have to improve the valuation of the stock. What kind of catalyst do you see for the story in the near term that could help drive the improvement in valuation?

Well, as a new entrant into the market, we've got to prove ourselves over time. We have exceeded our projections from the IPO, both in acquisitions, FFO and AFFO through the first 2 quarters. We did our first public debt offering. We locked in 10-year money at about 2.6%, which I keep telling John, we should do more of it, but that looks really good right now. We got through that. We were able to increase our dividend last year by 6%. And then one of the things that we got through in January was a lockup and now 100% of our stock is in the market, and we've moved through that. So we've moved through a number of the steps we had to take to prove to the market that we were going to do what we said we were going to do. And we believe that, that we need to continue to explain to the market the advantages of where we are buying shopping centers and then the machine we put together that is able to maximize the value of those properties.

So you mentioned earlier that the competitive position of your portfolio didn't really change with the pandemic. But maybe asked a little bit differently, what -- is there anything that has permanently changed in your business overall with the pandemic? And how could that kind of impact earnings growth going forward?

I think there are a number of macro things that have been very beneficial to our business. And the pandemic, as we have said to many times, accelerated some of that. Suburbanization has been very helpful to us. Our shopping centers are located in the suburbs. That's been a big positive for us. Work from home has been very advantageous. People being at and near our centers more of the day, creates them more buying opportunities for our retailers. And our groceries have really thrived during this -- during the pandemic. We thought that, that would bounce back. It hasn't. There's continued strong demand for the grocers, and the grocers continue to operate at a very good level. We also -- buying local is something that you kind of hear is a buzzword, but it's actually real in a lot of these markets where people like to buy stuff close to home and they like to buy from [ local retail ]. We have that, and we are that. The pandemic didn't cause omnichannel to emerge, but it did accelerate that. And the problem that retailers are facing today is last-mile delivery. And one of the biggest solutions for last-mile delivery is having a place where people can shop close to their home. That -- we have become one of the omnichannel solutions for a lot of retailers. And whether that's Starbucks and Chipotle or whether that's Kroger, that has been very positive.

And Bryan, one of the positives coming out of suburbanization is the fact that national retailers are identifying suburban locations as being higher-margin locations for them. The CEO of Chipotle, when they announced earnings in the last month, came out and said that they're going to have a renewed focus on adding stores in the suburbs because what they found is that their sales volumes are comparable, but their costs are lower and therefore, their margins are higher. And we are being a real beneficiary of that from a large number of national retailers that are increasing the number of stores that they have in the Phillips Edison portfolio.

Okay. So along the lines of last mile and you noted the higher shipping costs and kind of logistic pressures. Are tenants -- are your tenants looking and having conversations with you about utilizing their store square footage differently than they were 2 years ago?

Yes. I would say conversations, yes, but actual actions have been a lot less. I mean there are a lot of people testing things, but there has not been -- I mean our -- we thought there'd be contraction in terms of the need for space and -- but most of them are actually expanding their footprint. But in terms of true doing micro fulfillment, they're still -- they've got ways to go there. And the only exception there is the Ocado stuff that Kroger is doing, where they're using remote warehouses to fund -- to do their BOPIS. And what most of the retailers are driving the consume towards as BOPIS because buying online and picking up the store for them is a much more cost-effective way to deliver goods than to actually have to deliver them. I mean they do have to be omnichannel. They know that they've got to deliver, but delivery is their last choice in terms of profitability.

Bryan, one of the things we did during the pandemic is we implemented a program we call Front Row to Go, which allows all of our retailers to have access to pick up if their customer wants pick up. And we've implemented Front Row to Go in over 95% of our portfolio. The only reason it's not 100% is there were certain municipalities, which wouldn't allow us to do it. And if they would, we would have. And so we've allowed all of our tenants to take advantage of the growth in omnichannel to the extent they want to do that. And then BOPIS is something that over 95% of our grocers have, one of the concerns we had at the time that BOPIS began to become a meaningful component of grocery sales was the impact it was going to have on our in-line tenants because our concern was that with the customer buying the goods online and just coming to the center to pick them up, the goods would go in the car and then the car would leave and the cross-shopping wouldn't continue. What we've actually found is in every center where the grocer offers BOPIS, our in-line tenants are doing better because of that. And what we found is, is that the customer actually now has an incremental 30 to 40 minutes that they used to spend pushing the cart through the aisles. They are no longer using that 30 to 40 minutes to do that, and they're getting a sandwich. They're getting their haircut. They're going to the gym. They're going to the bank, et cetera. And so the in-line tenants are benefiting from these locations where the grocer has put BOPIS in as an alternative.

Okay. So when you mentioned Front Row To Go, that's the parking -- is that a part parking...

Dedicated parking spaces that allow the customer to access goods in a pickup format.

Okay. Great. And you mentioned 95% of retailers have BOPIS in your portfolio?

95% of our centers have Front Row To Go, and over 90% of our grocers offer BOPIS.

Are the -- are your retailers giving additional incentives to drive BOPIS economic incentive to the customer? How are they pushing that?

Yes. They're driving it. We're not driving it. They're really driving that through their customer base.

Because the grocer -- if you understand the economics of delivery, they're terrible for the grocer. The average grocery basket is circa $100 to deliver it depending on where you are, is $10 to $15. And there's typically $3 to $4 of profit in that $100 basket. So if they're $3 to $4 of profit and it costs you $10 to $15 to deliver it, you're losing money on every single delivery. And you've seen even Amazon now begin to charge for grocery delivery because grocery delivery is not profitable. So the retailers want to drive the customer that wants to shop online to do BOPIS because the margins on BOPIS are better than they are on delivery. In addition to the economics being better for the grocer, the customer prefers the convenience of BOPIS to delivery. Because if you have groceries delivered in most locations, you have to pick a window. It's typically a 2-hour window. Sometime they hit it, sometimes they don't. And you're sitting around for that 2-hour period of time. If they don't hit the window, those groceries are probably sitting someplace that you don't want them to sit. And therefore, the customer has a clear preference for the convenience of BOPIS relative to delivery.

Okay. Great. And I just looked over at my screen, I have a number of questions over here. So I'm going to go over to the crowd. And the first one is, given your high level of occupancy, how will this influence your decisions with tenants on rate?

Well, we are -- our small store occupancy is about 93%. We think we've got about 2% on top of that, that we will add over the next 12 to 24 months. We have had really positive leasing exposures. So hopefully, we can accelerate that. And what we've been able to do with rents is we believe we're getting market-leading spreads from both renewals, which are 90% -- 90% of our neighbors renew, which is between 85% and 90% renewed. That's been a great driver of value for us. We believe that, that -- we've seen that continue. It's been fairly consistent for the last 3 years. So we think that, that will be -- that's been another -- a positive sign from that.

Can you talk a little bit about tenant health? You mentioned 2 of your -- where you're the largest landlord for Kroger, second for public. Can you just give us a view overall of the health of your tenant base?

Well, the grocers are about as healthy as they've been in a long time. I mean they're -- they saw big increases in sales during BOPIS. They seem to be continuing to be able to drive that. So they are -- our grocers are as healthy as they've been. The small stores, there was some weeding out that you get something like the pandemic. So some of the weaker neighbors did leave in that time. So I -- we keep our -- we try and keep our health ratio for our small stores in that 10% range, which is basically 10% of their sales as total rent and pass-throughs, and we're well within that range. So we feel like they're in a really healthy spot. And the real question for us is how healthy is the consumer. And with 3.8% unemployment and the current financial state of the consumer, we're very optimistic about that.

Bryan, the stat that we think speaks the best to the health of our tenants is the fact that, as Jeff indicated, we have a renewal rate of almost 90%. And so 9 out of every 10 tenants is re-upping and that's after absorbing 2.5% annual increases and then renewal spreads in the high single digits. So our view is that's a pretty compelling indication that our retailers and our centers are healthy and want to continue to operate their businesses in our centers.

Can you talk about the benefit of a national strategy? I think this is probably with regards to leasing as opposed to a regionally concentrated strategy.

So we've had a national footprint since we started the company. We -- the first center was not where our headquarters were. And we've looked at it a number of ways. And what we've found is that buying the right center is much more important than concentration. And even with the additional overhead it takes to operate in disparate areas. That is -- our returns show that, that is not the case. Now it's important to note that we do have 300 centers. So we do have concentrations in markets. And our biggest market -- it's our Atlanta, Tampa, Phoenix, Chicago, Dallas, Denver and Sacramento. So those are not -- I mean we're not talking about small markets. We're just not talking about coastal markets.

And where we really see the benefit of the national strategy, Bryan, is in acquisitions. And as Jeff mentioned, we believe that there are 5,800 shopping centers in the U.S. that meet our acquisition criteria. So they're anchored by the 1 or 2 grocer in the market, and they have a demographic profile in terms of median household income and population density that we know the #1 or #2 grocer will be successful with. And just to put a round number on the total size of that 5,800 centers, it's about $180 billion. And we really believe that, that's an advantage to us because we have a broader and a deeper acquisition universe to compete in. And that broader and deeper market allows us to, a, get better going in yields than the more competitive top 25 MSAs. We get equal to or better same-store NOI growth out of those assets over time, and we put less capital back in. And so the combination of those 3 elements, we believe, gives us a better ROE on our acquisitions than if we were to be only focused on a limited number of MSAs.

Got it. Let's jump into a question on the acquisition environment. And you mentioned 5,800 shopping centers, $180 billion. Can you talk about just the overall environment, cap rates, competition that you're seeing? How have cap rates changed since the IPO? And do acquisitions still pencil?

So our target is an 8% unlevered IRR, and that's really the driver in terms of what we can and what we will and will not buy. And so as we sort of look at the acquisition market, it has gotten more competitive. There are -- we -- as I said, we weren't very sexy, we're a little sexier in the grocery anchored shopping center, probably more sexier than we've ever been in terms of the grocery-anchored shopping center business. We do have a lot more entrants into it. We do think we're going through a questioning among investors about the spread between -- and the risk rewards sort of between industrial, multifamily and necessity-based grocery-anchored retail. And that spread is very -- is still very large. And we think that some of the cap rate compression, some of the large transactions that have happened in our space are all indicators that there is some repricing going on in that regard. So we have seen more competition, and it's making our job of getting that 8% unlevered IRR property more difficult, but we so far have bought $100 million worth of properties this year. Our target for the year is between $300 million and $400 million. So we're well along in our target. There are more properties on the market as cap rates have compressed and expectations of sellers have accelerated, there's more products. So there's a ton of product in the market. It's going to be being disciplined to make sure that we get the right -- we buy the right properties with the ability to get to that -- those returns.

Right. So you had a strong leasing year in 2021. Are you seeing that strength continue so far in 2022? And can you speak to the ability to kind of push rents relative to what they were a pre-COVID levels?

So we're in -- as you probably heard from a number of our peers, we're in a really good market, probably as good a market on leasing side as we've seen a lot of those macro things that I talked about earlier, are driving retailer demand. There's a particularly strong retailer demand for our size stores, which is about 20 -- between 2,000 and 2,500 square feet, that's where the vast majority of the demand is. And we're taking advantage of that. We're getting market-leading renewal spreads as well as new leasing spreads. Our renewal spreads are in the high single digits, and our new leasing spreads are in the mid-teens.

Yes, Bryan, we're seeing rents today above where they were pre-COVID. And our NOI is returned to pre-COVID levels in Q3 of last year. So we're ahead of some of our competitors in that regard in terms of getting the business back to where it was pre-COVID. And our foot traffic levels are above where they were pre-COVID as well. One of the things that we think is driving that is the work-from-home dynamic which is increasing the foot traffic at our centers as more people are working from home and therefore, shopping at our centers.

Okay. Let's talk a little bit about capital allocation. Can you walk us through your top priorities for capital allocation in 2022?

There are 2 sort of growth vehicles. One is the acquisition, which I talked about earlier, which is a target of $300 million to $400 million of net acquisitions this year. So that's one part. The other is our sort of development -- redevelopment business, which is about a $50 million a year business. That business is basically by building single tenant and small multi-tenant spaces on the peripheral of our shopping centers. And we -- that's been a business where we can get 9-plus percent yields on, and we like that business a lot. We wish we could do more of it. It's a lot of work and going through the approvals and is -- we'll do as much of that as we can, but we've targeted $50 million a year of that.

Okay. And so as you think about that external growth, how do you plan to fund that? Can you walk us through the different ways you thought about that?

Yes. So when we targeted the size of the IPO, our goal was to be able to meet those targets that I just laid out over the next 3 years without having to go back to the markets and to maintain a debt-to-EBITDA in the low 6% -- 6x rate. So that we have a 3-year runway to do that growth based upon where the balance sheet is today.

Okay. Another question from the room. What's the sustainable long-term NOI growth of your portfolio?

Yes. We think, Bryan, historically, we've generated same-store NOI growth between 3% and 4%. And that's in a 2% inflation environment. So we think we can get real same-store NOI growth of 100 to 200 basis points above inflation. I mean one of the obvious questions that we're wrestling with right now is, where is inflation and how are we going to be able to pass that through? I mean it's clear that inflation is no longer "transitory" and we are in a higher inflation environment than we've been in for some time. But that 3% to 4% assumes a moderate inflation level. And if we get higher inflation, we think we'll get real growth of what we've seen historically of 100 to 200 basis points.

Okay. Speaking of the higher inflation, I skipped over an inflation question. Are you guys prepared to handle this inflationary environment, which we haven't seen for 30 years?

What we're watching very closely is really the consumer and how they're going to react to this because that is our -- that's what will drive the retailers. And my feeling is it's too early to know how much the retailers are going to be able to pass through to the consumer. As of today, there's been, what we're hearing, very little resistance to the ability to pass that through to the consumer, but that's something we want to watch closely and keep -- because that -- our retailers do better in a low -- moderate sort of -- not super low, but a moderate inflation environment. If you hear what Kroger has talked about over the last probably 10 years is that the low -- really low inflation environment of 1% to 2% has put pressure on their margins. They're much more comfortable in that 3% to 4% kind of range. We're certainly not looking for any kind of hyperinflation, but that kind of is very helpful to the margins on the grocers.

And on the balance sheet front, clearly, inflation is going to drive rates. And our debt today is virtually all fixed, and we don't have any maturities until 2024. So that component of the impact of inflation on our business model, we're insulated from at least through 2024. And then one of the important components of our business model is the fact that we're in necessity retail. 75% of our rents come from retailers that are offering necessity goods or services. And we think necessity retail is a hedge to inflation because, obviously, the consumer will be less impacted on necessity retail than they will on discretionary retail in an inflation environment.

Okay. So within your $300 million to $400 million of net acquisitions, are there any geographic areas that look more attractive to you than others today?

So about 6 or 7 years ago, we put together an algorithm that we used, and we back tested against the almost 400 centers that we bought and managed over time. We -- that has been a strong guide in terms of what we buy. As I said earlier, we compete on the corner of Main and Main. And the market we're most interested in is that market -- that submarket, how will our center compete in that submarket. The algorithm does drive us towards more growth markets and the markets that -- where there's a higher education level. And so you would expect that those will be the places where we grow the portfolio more robustly. There are also the, obviously, economic issues of the competition, and we just lost a deal this week to Publix. They've been out of the market for probably 2.5 years. They bought -- they priced -- see us by a bunch in terms of a property that they bought. So Florida will be a tougher market for us to buy, and those types of anecdotal stories are what will get us into certain markets and out of certain markets as time. But having a national footprint does allow us to shop across the country for inefficiencies, and we think gets us the ability to buy better yields.

And the 7 -- we bought 7 centers, Bryan, since the end of the third quarter in the markets that those 7 centers were located in is Denver, Austin, Sacramento, Las Vegas and Washington. So that gives you a pretty decent perspective on the kind of markets that we're looking to acquire assets in.

Great. I have one mandatory question that I'd ask for rapid fire. ESG, what is your #1 ESG priority for 2022?

We started working with [ Class B ] about 2 years ago. We're in the process of doing our second report. Our goal is to continue to see constant improvement across the board. Our biggest challenge is going to be on the environmental side. And the other piece of this that we're focused on is making sure we come up with a measuring stick that is consistent across the industry because that's, I think, a big challenge is it's -- you -- people can talk about these things, but what we've got to get a consistent measuring stick. So we know we can really know what everyone is doing. So we're working with the ICSC to help them work through that. We're going to try and help find a way to come up with a standard that is universal that accurately gets us to true ESG improvements.

Great. Jeff, we'll close with our rapid-fire questions. What will same-store NOI growth be for the shopping center sector overall in 2023?

3.5%, assuming inflation stabilized around 3%.

Great. And what will the 10-year treasury yield be a year from today?

2%.

And finally, will the shopping center sector have more or fewer public companies a year from now?

Fewer.

Great. Thanks, Jeff. Thank you.

Thanks, everybody.

Thanks, Bryan.